The price of gold has finally broken out above the $1,000 level. It is interesting that few commentators, other than confirmed gold bugs, have remarked upon this landmark event. Even more remarkable is the underlying technical behaviour: there is very little bull market hype in the price performance.
One indicator many pundits watch is the Commitments of Traders reports. These break down short and long positions into non-commercial and commercial positions, and the theory goes that the commercial traders are usually right. This time, the commercials have not been so clever, having been substantially short over a rise from $900 in early August to over $1,050 today. One of the quotes I picked up recently, was “when you own gold, you are fighting every central bank in the world”. This is no longer true, and that is also a remarkable change.
The Chinese have quietly become the largest gold producers in the world, and together with the Russians are stock-piling. These are good central banks to have on your side, and one suspects that they are under-reporting their positions. Various central banks have been sellers over the last few years, and these sales are no longer hanging over the market. Since 1999 the central banks publicly bashing gold have reduced their holdings by 3,780 tonnes, including of course some of Gordon Brown’s infamous sale. These sales represent 28% of these central banks’ total holdings ten years ago.
But there is a problem, and that is central banks do not tell the truth. No one knows what they hold, we only know what they tell us. In January 2006, an analyst at Cheveraux estimated that the central banks actually owned between 10,000-15,000 tonnes less gold than they reported. The reason stated was that the missing gold had been lent or leased out to the bullion banks and had been absorbed in the market. Effectively, the bullion banks have a short position to the central banks.
While figures such as this are guesswork, we do know that significant amounts of gold have been leased, and the very low lease rates have formed the basis for many years of a lucrative carry trade. It works like this: the central bank lends or leases bullion to a bullion bank typically at less than 1%. The bullion bank sells the gold in the market, and may or may not enter into a delivery contract with a mining company to cover his short position. The bullion bank invests the proceeds of the sale in bonds, or similar instruments, with maturities to match. The net result is that the bullion bank’s total cost of borrowing including the hedge is considerably less than the income from the bond.
For many years this was a very lucrative play, and gold was going down, so there was no need to cover. That certainly would have led to a substantial short position. However, if the short position still exists, the losses are buried in the balance sheets of Morgan Stanley, Goldman Sachs et al. None of this is reflected in official positions, partly because leased gold is still owned by the lessor, and also because central banks conceal the truth. Whatever the true position, the central banks have tried very hard to keep the price of gold down, and the breakout last week is final evidence they have failed.
The thing that is so heartening in this move is that the “little guy” has got it right. For some time, gold coins have been in very short supply, and the number of small investors holding ETFs and similar vehicles has been increasing. Last week, Harrods began selling gold bars to its customers. It is the larger investors who have missed the boat. They have been preoccupied with the deflationary outlook, or trading out of one fiat currency into another. The idea that gold should be a core component of a portfolio is currently accepted by very few of the bigger players.
So what are the dangers to a rising gold price? A return to sound money signalled perhaps by a rise in interest rates is the most obvious candidate, but there is no evidence of this happening in the foreseeable future. The political imperative is to keep interest rates low to help foster economic recovery. The fact that this policy has failed to stem the contraction in bank lending is likely to lead to more easing, through central banks monetising government debt at a quicker pace. Gold may be vulnerable to a dollar bounce, in which case it may hold its value in other currencies.
But so far the lack of general interest suggests that there is more upside to come, with the next banking crisis an increasing rather than a diminishing possibility. With or without a banking crisis, the balance of power has been tipped away from the Old World’s central banks, and perhaps their inexactitudes of the last four decades will be finally exposed.